As a benefit or incentive to employment, companies often offer private pension plans to their employees. These pension plans may come in a variety of forms. In general, however, each pension plan generally acts as a form of a retirement savings plan in which the employee, or plan participant, is entitled to receive certain benefits upon retirement or some other triggering event. To provide for payout of these benefits over time, the funds of a pension plan are generally invested in equity and debt securities that ideally provide a return on investment. For example, a typical strategy for investing the funds of a pension plan is known as a “60/40” strategy, meaning the funds are generally invested in about 60% equities and about 40% bonds.
In offering a pension plan to its employees, the employer is bound by certain laws and regulations to ensure that the plan is adequately funded and able to meet its obligations to the plan participants. A sponsor of a pension plan is also bound by a fiduciary duty to act solely in the interests of the plan participants. In addition, under certain circumstances a plan sponsor may be liable for losses arising out of decisions concerning the investment of plan funds. In meeting these duties and obligations, a sponsor will often need to devote a significant amount of time and resources to managing the pension plan.
As a result of the above obligations, the decision of an employer to offer a pension plan carries with it certain risks and liabilities. The funds of a pension plan may not always be sufficient to cover the obligations to the plan participants. In particular, the funding of a pension plan is susceptible to a combination of both investment risk and longevity risk (i.e., the risk of servicing plan participants over lives that are longer than expected). This underfunding of the plan may result in the need for the sponsor to infuse the plan with additional funds, and may also result in higher guaranty premiums as required by the Pension Benefit Guaranty Corporation (PBGC). In addition, the need to make payments to a pension plan may have a negative effect on the financial statements of a plan sponsor, and may lower sponsor shareholder equity. Finally, the inability of a sponsor to adequately fund the pension plan could also result in inadvertent termination of the plan.
In view of these risks, it may be more beneficial to both a plan sponsor and its participants to deliberately terminate a plan in whole or in part. For a sponsor, termination of all or a part of a pension plan may eliminate liability and overhead, and may allow for its pension obligations to be removed from the company's balance sheet. For a participant, a planned termination of the pension plan may lower the risk to his or her future benefits by shifting payment obligations under the plan to a larger or more established or more credit-worthy provider of benefits.
The only method available under the law for voluntarily terminating a pension plan is to purchase annuities. These annuities are purchased from commercial life and annuity insurers. However, termination through this method has significant drawbacks. First, with a commercial insurer that is a stock company, the benefits of any surplus capital over the amount required to fund the annuities inures to the benefit of the stockholders of the insurer, not to the pension plan participants who become policyholders of the insurer. Second, as the credit crisis of 2008 and 2009 illustrated, commercial life and annuity insurers are free to invest funds using strategies that expose policyholders to significant risk. As a result, a commercial insurer may opt to pursue a relatively risky investment strategy, such as a 60/40 strategy, which may provide for short-term gains to the stockholders of the insurer at the expense of increased risk to the payout of benefits to the policyholders. As shown in FIG. 1, the use of a 60/40 investment strategy carries with it a higher probability of a risk.
In addition, a commercial insurance company has exposures to risks on its other business lines, such as term life insurance. For example, a life insurance company offering life insurance plans may be exposed to risks associated with potential mortality catastrophic events, such as pandemics. Likewise, the capital supporting pension plan obligations may end up tied up in risky legacy investments, such as residential mortgage backed securities, commercial mortgage backed securities, commercial real estate loans, and commercial real estate direct investments. As a result, the new policyholders from the terminated plan may be subject to the risks of the insurer's legacy investments and exposures, as well as the “surplus strain” associated with writing new business.
In calculating a premium for its annuities, a commercial insurance company takes into account factors that are not directly related to the costs necessary to cover its annuity obligations. In particular, a commercial insurance company will calculate its premium according to rating agency and regulatory capital requirements, the weighted average cost of that capital (WACC), and the company's targeted return on capital. Commercial insurance companies also carry additional overhead due to advertising expenses, broker commissions, and salaries of marketing employees, new product developers, and underwriters. This overhead may be reflected in additional costs to the plan sponsor in purchasing the annuities, or in reduced payments to policyholders.
Furthermore, only pension plans of smaller size may be able to execute a standard termination using annuities offered by commercial insurance companies since there is insufficient overall capital capacity in the commercial insurance market. FIG. 3 shows U.S. annual sales over the last ten years of the types of annuities used in pension close-outs (“single premium group annuities” and “terminal funding annuities”). According to a 2009 LIMRA International report, the average aggregate total amount of pension plan annuities issued each year has fluctuated between around $2 billion and $3 billion per year. The limited capacity of the commercial market place has the effect of excluding over a hundred companies that have pension plan assets exceeding $2 billion, and preventing these companies from annuitizing their pension plans. Also, according to the 2009 LIMRA International report, cumulative sales during the ten previous years were approximately $25.1 billion. The top 20 U.S. pension plans, by contrast, held average assets of $28.8 billion. Hence, the annuitization of an “average” top 20 pension plan would consume ten years of total insurance industry capacity for this type of annuities. In other words, there is not enough capital capacity in the commercial insurance market to allow large plans to annuitize.
In addition, life insurance companies often calculate the amount of premium they charge the buyer of an insurance product by, among other factors, incorporating the cost of the regulatory capital that the insurer must hold, as required by insurance laws and regulations (referred to as “risk-based capital” or “RBC”). The amount of required risk-based capital for U.S. life insurance companies is established by the National Association of Insurance Commissioners (“NAIC”). The NAIC publishes model insurance statutes that have been adopted as governing law, largely as proposed by the NAIC, by the 50 states and the District of Columbia. These model statutes establish a risk-based capital formula for U.S. life insurance companies based on several risk factors, including asset risk (the “C1” component of the RBC formula), insurance risk (the “C2” component), market risk (the “C3” component), and operational risk (the “C4” component). The C2 component, insurance risk, may also be referred to as longevity risk in the context of fixed annuities. The C3 component, market risk, may also be referred to as, or may include, interest rate risk. The C4 component, operational risk, may also be referred to as business risk or premium risk. The statutory RBC requirement for the C4 component in a given year is based upon the amount of premium collected by a life insurance company during such year.
Insurance companies generally collect premiums over many years, but for certain products the insurance company collects only one single premium at the inception of the contract (“single premium” products) that compensate the insurance company for the many years of risk covered by the policy. For such single premium insurance products, such as those annuity products that qualify for pension plan termination, the RBC requirement is high in the first year because the C4 component is based on one large premium that the pension plan pays upfront. In subsequent years, the C4 charge is zero, because the insurance company collects no additional premiums for the policy.
To illustrate, the C4 requirement (after taxes) can amount to approximately 2% of the premium. For a hypothetical single premium group annuity of $1 billion, the C4 requirement would amount to approximately $20 million in the first year and zero in subsequent years. The cost to the insurance company of holding $20 million of capital in this example is high. As a result, requiring a commercial insurance company to maintain sufficient capital to cover the risk of an assessment is inefficient where the company issues annuities only infrequently or only on a one-time basis.
Insurance companies typically implicitly recover the cost of their required capital by pricing it into the premium for policies they sell. In general, insurance companies calculate their required capital on an aggregate basis rather than a policy-by-policy basis. It may not be practical for insurance companies to calculate policy-by-policy requirements, because of the large number of policies they manage, the many different policy inception dates, and the practice of most insurance companies to pool their investments. The latter especially makes a policy-by-policy calculation of required capital especially difficult, because RBC rules require the aggregated measurement of investment and interest rate risks and also apply co-variance factors that adjust the result for correlation across risks. Hence, in general, insurance companies calculate required capital on a “top down” basis rather than a “bottom up” basis when quoting a premium for an insurance policy.
In view of the above, it would be beneficial to be able to provide a system and method for terminating a pension plan that avoids all or some of the above shortcomings. In particular, it would be beneficial to provide a termination program that provides pension plan participants with greater security and less risk, and that allows pension plan participants to be insulated from the risks of the business for the benefit unaffiliated policyholders. It would also be beneficial to provide a program that transfers legacy liabilities of a plan provider to a party that is better-suited to handle the liabilities going forward, and allows the plan provider to free up capital. In addition, it would be beneficial to provide a termination program that allows pension plan participants, rather than stockholders, to share in any excess capital, and that (a) eliminates the need for overhead costs associated with marketing and advertising services, and (b) inefficient pricing related to the capital charge associated with the C4 component of the RBC formula. Finally, such a program should comply with applicable rules and regulations and should fulfill existing Department of Labor standards.